Ben Bernanke went after the swaps trading measure in the Wall Street reform bill again yesterday, joining the establishment carping that it would weaken financial stability. Paul Volcker, Sheila Bair and others have made variations of this argument in recent days.

Bernanke, in a May 12 letter to Senate Banking Committee Chairman Christopher Dodd, said the proposal, part of the Connecticut Democrat’s regulatory-overhaul bill, would harm the Fed’s ability to monitor systemic risk among financial firms. He had previously spoken privately against the proposal crafted by Senate Agriculture Committee Chairman Blanche Lincoln […]

“Prohibiting depository institutions from engaging in significant swaps activities will weaken the risk mitigation efforts of banks and their customers,” Bernanke wrote. “Depository institutions use derivatives to help mitigate the risks of their normal banking activities.”

The provision would ban the Fed from lending to any swaps dealer or major swap participant, regardless of whether it is affiliated with a bank, Bernanke wrote.

“Experience over the past two years demonstrates that such broad-based facilities can play a critical role in stemming financial panics and addressing severe strains in the financial markets that threaten financial stability,” Bernanke wrote in the letter, which was also sent to Alabama Senator Richard Shelby, the top Republican on the Senate Banking Committee, and Senator Kirsten Gillibrand, a New York Democrat.

Tell me, Ben, how did banks do with “mitigating risk” when they controlled 90% of the derivatives market in 2008? Did the presence of derivatives trading desks – and by the way, under this plan banks could still BUY derivatives so the entire premise is faulty – protect their super-risky commercial banking activities, or did they CAUSE THE PROBLEM by promoting securitization and encouraging risk?

As for the idea that the swaps measure would stop Helicopter Ben from being Helicopter Ben, that would only be true if banks decided that their trading desks and gambling activities were more lucrative than the discount window or whatever special facilities the Fed could set up. In other words, if the banks want to gamble, they have to accept their own risk. If they don’t, they can get folded into the protections given to stimulate lending and save unsuspecting depositors from ruin. That sounds perfectly sensible.

Dean Baker writes:

There are reasonable arguments that can be made on this issue, but these did not appear in Mr. Bernanke’s letter. At the center of Bernanke’s argument are two points that are just not true. He argues that the legislation would prevent banks from buying derivatives to hedge interest rate risk. This was not the intent of the rules and this is not how most people other than Bernanke are interpreting them. The issue is whether commercial banks should be acting as the intermediaries in trading derivatives, not whether they can buy derivatives as end users, just as any other end user would.

The other false concern raised by Bernanke is that derivative trading will be taken away from relatively closely regulated bank holding companies and transferred to more poorly regulated parts of the financial system. This is a false concern because the Ag Committee language only requires that the trading be taken away from the commercial banks that are protected by government insurance. Banks would be allowed to spin off divisions that are still within the bank holding company, however these divisions would not enjoy the special protections provided to commercial banks.

Not only is Bernanke essentially lying to Congress, there’s a bigger meta-lie about the value of derivatives in general, particularly the explosion we’ve seen in them after 2005, when they became privileged in bankruptcy proceedings. Ezra Klein has a very good piece on this today.

These derivative products barely exist in the 1990s. They become bigger in the early-Aughts. Then they explode after the 2005 Bankruptcy Bill gives them favorable treatment in bankruptcy proceedings. So we’ve got a pretty good natural experiment here: Has the post-2005 economy been much better and more stable than the pre-2005 economy? Or has the Aughts economy vastly outpaced the ’90s economy?

Of course not. And nor have there been massive technological or sectoral changes that make these economies so different that entirely new financial instruments are needed to survive them. Instead, it seems pretty clear that banks developed a new product that increased their profits, government was lobbied to give it favorable treatment, and then it took off like gangbusters.

Now, when government – at least some of it – recognizes the extreme risks involved in derivatives, and moves to separate them from the broader financial economy, as well as tightly regulate the market, the lobbying begins anew.

I think the finance lobby desperately wants to kill this portion of the derivatives piece in secret. They may want to wait until Blanche Lincoln’s primary, which is why the best thing we can hope for is a June 8 runoff. Because otherwise, Evan Bayh or some other lackey will offer an amendment to strip it out, or they’ll fold it into a quick-strike manager’s amendment, or just as likely, take it out in conference committee.

Either way, groups like Americans for Financial Reform, which claims to support the swap trading desk spin-off, had better get off their buns and start loudly defending it before it gets whittled away.